The Bubble in Corporate Debt

Sorry to be not-so-rosy. Besides the sovereign debt behemoth that I’ve written about (and the $6 Trillion more since), there are deleveragings in-store. Corporate America is more leveraged than it’s been in decades. Corporate debt levels are up 75% since 2008, the quality of corporate debt is at an all-time low, and one out of every 5 companies is struggling just to pay the interest on their debt. Investors seem fairly confident that the Fed’s stimulus will work: the S&P has bounced 23% off its low and IG and HY bond funds have rebounded comparably.

The COVID19 shutdown itself is doing irreparable harm to the vastly intricate web of human livelihood called our economy. The rates of suicide, depression, and alcohol & substance abuse, are already up, along with mortgage delinquencies. Food shortages and civil unrest are anticipated. Most of the irreparable damage is being done to small businesses, which account for 70% of new job creation. But as I indicated with regard to the sovereign debt bubble, this economic shutdown is also a catalyst to trigger preexisting debt comeuppances, and this includes the bubble in corporate debt.

Despite the apparent sanguinity, many companies are borrowing to make their payrolls and other basic expenses. And one important feature of the Fed’s stimulus efforts is that, apart from the airlines and small businesses, the rest of the companies eligible for the central bank’s bailouts aren’t getting a true bailout in the form of free money; the Fed is extending loans to them that noone else will. So their leverage ratios are just getting worse. Furthermore, only investment grade companies are getting the loans. Junk-rated companies aren’t getting the aid.

Companies’ debt/earnings ratios are about to take off, which will lead to an increasing number of downgrades. This is already happening: S&P downgraded almost 740 North American companies in Q1; more than any quarter since the last financial crisis. And they have so-far downgraded another 400 in April, so the number of downgrades is accelerating. S&P expects a 10-13% default rate among junk credit by year-end, which would be the highest in 40 years. The high yield credit spread blew out to around 1100 basis points on March 25 and has since declined by over 700 bps, but S&P believes the spread will soon approach 1600 bps.

Companies binged on low rates and for now the market is not yet demanding that they atone. But with capital formation and jobs being destroyed at atrocious rates, it probably wont be long. Nations, the banking complex, and corporate America are all underwater in debt, as well as states and municipalities (muni bonds are another problem now).  I do not hope for people to experience financial pain – I myself am in an iffy situation now. However, I would need the people talking about getting ‘back to normal’ to change my understanding of such matters before I could buy-into their outlook.

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